Many investors use the approach of the New Year to reevaluate their trading and investment strategies as they once again try to outsmart the market. Recent years have seen a proliferation of leveraged ETFs that promise to double or triple the return of the underlying index. While this seems like a great way to capitalize on an investment thesis, more often than not investments in these leveraged ETFs become a sucker’s bet. This derives mainly from the way that the leveraged returns are calculated, i.e. they are designed to double or triple the daily return and are thus reset each and every day. This is a critical point because over time this can create tremendous tracking error. To give you a sense of this, imagine that two investors each have $1000 to invest. Investor A puts that money into the market and investor B places their money in a leveraged ETF that promises twice the daily returns of the underlying market. Now let us assume that the market essentially goes nowhere over the next 14 trading days and this can be stylized as up 1% on day and down 1% the next day. What would happen to the two investments?
|Day||Daily Return (Market)||Daily Return (2X Leveraged ETF)||Investment Value (Market)||Investment Value (2X Leveraged ETF)|
Table 1 clearly shows that over the course of those 14 trading days that the leveraged investment does slightly worse that than underlying market. While this difference does not seem to be a lot, keep in mind that this is only 14 days. If we look after 60 trading days, the market returns -0.30% versus -1.19% for the leveraged ETF. So the gap will only grow over time. As such, in a relatively flat market, holding leveraged ETFs is an increasingly bad bet.
The performance problem only increases if the market becomes more volatile. Rather than assume a 1% gain followed by a 1% loss, we can look at a 3% gain followed by a 3% loss.
Table 2 clearly shows that the underperformance of the leveraged ETF grows in volatile markets. After only 14 days the market is down -0.63% versus -2.49% for the leveraged ETF. Again this gap only increases with time, where after 60 trading days the market has returned -2.67% versus a whopping -10.25% loss for the leveraged ETF. The underperformance is not just in flat markets. Table 3 examines a market that is slowing moving up over time.
While the leveraged ETF does outperform the market in this scenario, it is not the double that one would expect. Of course, the returns that I choose are arbitrary and are only used to demonstrate a point: the tracking error with leveraged ETFs can be dramatic. There are, however, scenarios where the tracking error works to your advantage and this is when you have a market that is trending. Table 4 shows the returns in a market that is trending higher over the course of 14 trading days.
Under this scenario, the leveraged ETF returns more than double the market and this gap would only grow as the trend continued. So what is the net take home of this analysis? I think there are three main points.
1. Assume that the tracking error of a leveraged ETF only increases in time.
2. The tracking error can work for or against you, so it is best to model how you think the market will perform to determine whether or not to use the leveraged ETF and for how long.
3. You can use the tracking error in your favor. For instance, if you think the market will either be flat or trend down, then it makes sense to short a leveraged long ETF rather than go long a leveraged inverse.
Disclosure: No positions in leveraged ETFs